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Marcus and Millichap CEO: 'There's a transition going on’ in commercial real estate

Marcus and Millichap CEO Hessam Nadji joins Yahoo Finance Live to discuss the commercial real estate market, buyer-seller expectations, rising interest rates, economic uncertainty, and the outlook for consumers.

Video Transcript

[MUSIC PLAYING]

- Commercial real estate is taking a hit from higher interest rates, with the number of transactions in the second quarter falling 22% from a year ago, according to data from MSCI. Joining us now to discuss the state of the commercial real estate business is Marcus and Millichap CEO Hessam Nadji. Hessam, good to see you here this morning. So we are going into a more pronounced interest rate cycle. What do you expect that will do to the commercial real estate market?

HESSAM NADJI: Good morning. Great to be with you on the program. Well, of course, there is an impact on valuations, buyer-seller expectations as interest rates have gone up. If you step back historically, interest rates have actually been much higher than they are today. We're still well below the long-term average. It's the rapid pace by which the Fed has had to raise rates to fight inflation that's created this disconnect between buyers and sellers on exactly what that means on valuations.

Of course, because so many real estate investors, both institutional and private investors, use financing and debt in order to facilitate their investments in commercial real estate, it has a pronounced, very pronounced effect on valuations. But the difference this time around from '08, '09, and especially going into the pandemic in 2020, is that you have very strong fundamentals, both on the financial and market side. The banks are not sick. They're well capitalized. They're still lending.

And there is a pent-up demand of capital that needs a return. Inflation is another reason why some of that capital continues to come into commercial real estate. It's an inflation hedge. And the operations side of commercial real estate, occupancies and rents, continue to do very well.

And because this, if you will, recession, technical recession, job recession to come is likely to be fairly shallow, we don't anticipate a big operations problem. So there's a transition going on in the marketplace, as you would expect. But the fundamentals are still very strong.

- Has there been a material change to the commercial real estate market as a byproduct of the hybrid work environment compared to prepandemic?

HESSAM NADJI: Certainly in the office space consumption and new leases that are being signed, we see the hybrid workplace play a big factor in the reduction of footprint. And the space needs expectations going forward. The flip side of that, though, is when you look at some of the fastest growing companies, particularly on the technology side, they're actually acquiring office buildings. They're acquiring land to build future office buildings.

So the composition of space utilization is changing, for sure, to accommodate for more team and collaboration and less about the individual employee space. And the overall footprint currently looks to be shrinking. I think if you look two to four years out, when we have the next economic cycle, with job growth coming, and a lack of overbuilding, there's very little overbuilding going on in commercial real estate. I think they're going to offset each other as two factors, one being the reduction of footprint because of hybrid workforce and then the other being new demand coming into the market.

- We are also-- hi, Hessam, it's Julie-- we are seeing a lot of companies now start to talk about slowing hiring at the least and even outright cutting jobs in some cases. So are we starting to see any kind of changes being made? And I know real estate planning is a little bit further out, but are we seeing any kind of changes being made or slow down in expansion of space because of that?

HESSAM NADJI: It's certainly a concern-- good morning. Great to see you-- that we will need fewer workers. But most of our clients that we've been talking to, especially on the development side of the equation, are looking for opportunities to take older properties, older office buildings, and actually older properties in every segment, and improve them, upgrade them, bring them up to the current kind of a configuration that the market seems to need as a really good investment instead of building brand-new projects.

The current recession concerns or employee reduction concerns appear to be fairly short lived and shallow in the way that the expectations are looking for the next, let's say, 12 to 24 months. It's not expected to be a major recession with huge job reductions. So it's creating some hesitation in the market on the office side of the equation, for sure. But it's not really a long-term concern.

The bigger concern is this hybrid work environment. We're seeing a lot of focus on amenities, like fitness, childcare, and entertainment even to motivate workers to want to come back in at least three days a week, four days a week, whatever it is, depending on the company. There's a lot of focus on how to create a reason for people to want to congregate and come back into the office space.

- Separately, but I guess within the same market here for commercial real estate, we've also seen retail become more experiential. How does this change the type of square footage that companies may even look to acquire or lease within this commercial real estate market?

HESSAM NADJI: You actually bring up a great point in that one of the advantages of commercial real estate as a whole for average American investors who are families or partnerships, or even individuals, all the way up to the most sophisticated institutions, the life insurance companies, pension fund advisors, is the menu of choice. Apartment buildings, for example, within commercial real estate, have an incredible amount of reliability and cash flows and occupancies, and in this environment especially, rent growth. So they're the lowest risk, lower return type of property type.

And then you have shopping centers, especially older shopping centers, that have seen some obsolescence, that have seen some dark spaces. On the other end-- maybe even hospitality postpandemic. On the other end, where you have a great opportunity for turnaround investments, higher risk, higher return kind of investments-- so speaking of shopping centers, we're seeing a lot of investors come in and buy older shopping centers, invest in them, and partner with equity sources, capital sources to reposition those, in some cases an entire reuse of older shopping centers. But a lot of shopping centers can actually perform better if, to your point, they cater to the fitness, food, and entertainment component of what the consumer wants as that experience that they're not going to get through online shopping and then draw them back in, we've seen a lot of success stories around that.

- And finally, just quickly, as we see the Fed raising rates, I mean, the objective is to tighten financial conditions. Are you guys tightening your lending standards here in your financing for these projects that you're talking about?

HESSAM NADJI: Well, we're an intermediary for our clients, the borrowers, if you will. And our job is to basically shop for the best available financing through multiple lenders in the marketplace and secure for the borrower on behalf of the borrower as an intermediary the best terms and, of course, interest rates. And we're still being very successful doing that because lenders are actively lending. They have tightened their underwriting. They have increased their inspection of the assets and the quality of the buyer.

So there's more caution, without a doubt. But because the financial system is very liquid and because lenders are not having to look at internal problem solving and having literally a credit freeze like we had in 2008, 2009 in the Great Financial Crisis, we're not seeing a big pullback of financing at all, just more caution, tighter underwriting. And, of course, that is affecting valuations. I don't want to skip over that. But at the same time, there's plenty of equity and debt capital, which is what makes this particular phase in the market very different than '08 and '09.

- Yes, most definitely. And thanks for clarifying on where you guys sit that structure. Hessam Nadji, thank you so much for joining us, Marcus and Millichap CEO. Liquidity still out there, it sounds like, in the commercial real estate market.

HESSAM NADJI: Thanks for having me on.

- Thank you. Appreciate it.